With economic stimulus now turning to fiscal contraction, I thought it might be interesting to look back and see what I was thinking when the debate over the stimulus package was going on. This is from a post I made on February 9, 2009. Some of the details of the ARRA changed between that time and passage, but most of the changes were in the direction of making it smaller.

By and large I think my predictions were pretty good. The stimulus did help prevent a second Great Depression, but were not enough to prevent a long and lingering economic downturn. While not the main focus of the post, I did urge people to stay invested in the stock market, but was a bit on the chicken side. I urged people to go for very defensive type names. A month later, one of the greatest bull markets in our lifetimes started, and the economically sensitive stocks were the ones that led the rally.

I currently think the emphasis on immediate deficit reduction is misplaced. The economy is still soft, and we need more fiscal stimulus, not austerity. The Fed has been helpful by keeping rates at rock-bottom levels and doing large scale asset purchases (aka quantitative easing, QE). QE2 is now over (or will officially be tomorrow), so we are not going to be getting a lot of help on the monetary stimulus front.

Given the liquidity trap conditions, I have seen monetary stimulus as a poor second choice to fiscal stimulus, but if you are hurting, taking an Advil will help, even if the pain level really calls for something stronger.

Keep in mind that much of the fiscal stimulus at the federal level was offset by much lower spending/higher taxes at the state and local levels. While the ARRA did partially offset that through aid to the states, it was just a partial offset. Now with the ARRA funds drying up, the lower levels of government are cutting back with a vengeance.

The loss of public sector jobs is offsetting a big part of the job growth in the private sector. In the first quarter, reduced State and Local spending subtracted 0.5% from GDP growth. That drag is likely to only grow as the year wears on. I am also expecting to see some drag from the non-defense side of federal spending in the second quarter and beyond.

While overall second half growth should be higher than in the first half, I suspect that it will still disappoint many. I now expect that second quarter GDP growth will be lower than the 1.9% in the first quarter, but not by a huge amount, probably coming in at about 1.7%. I have put what I consider the key predictions in the post in bold (not in bold originally):

“There are some things in economics that are debatable, and others that are not. Among the things that are not debatable is that GDP is equal to the sum of consumer spending (C), investment spending (I), government spending (G) and net exports (X-M). This is an accounting identity, just like on a balance sheet how assets have to equal the sum of liabilities and equity. So keep the equation in mind GDP = C + I + G + X – M in mind in any commentary about the fiscal stimulus package. Memorize it — this will be on the test.

“It is a mistake to think of this recession as just another garden variety recession. It is something that we have not seen since the 1930’s in its basic character, but let us hope not in its severity. The jobs report on Friday showed that we are still accelerating to the downside. Look at Chart One and it is clear that this is nasty already, and it is likely that the February report will be just as bad.

“The absolute magnitude of the job losses already exceeds any previous post-war recession, although as I discuss below, things are a little bit better on a population adjusted basis. One has to go back to the early 1980’s recession to find anything of a similar magnitude, but that was a different animal. It was a deliberately engineered recession designed to break the back of surging inflation.

“This is a massive deleveraging of the economic system. It is the Keynesian ‘Paradox of Thrift’ writ large. Its dynamics are much more like what got us into the Great Depression. The only saving grace is that we now have some automatic stabilizers, the economy safety net that was not in place in the 1930’s, as tattered as that net may be.”

Chart 1
Job Losses Worst Since WWII

“A good stimulus package is the only thing that has a chance to make this just a very nasty recession, rather than the Great Depression 2.0. Yes the additional debt will be a long-term drag on the economy, but the government debt/GDP has been higher in the past (although not true for private debt/GDP). So there is still some room on the government balance sheet.

“We have a big-time shortfall in aggregate demand, and C is not going to go up — it can’t — and if C falls, then I will fall right behind it. Net exports can’t do the trick, especially not with every other country in the world down as hard if not harder than the US. The only improvement on that front will come from falling imports, but falling imports with no import substitution, just lower C & I demand.

“The only thing left is G. If anything, the original proposal was too small and too geared to tax cuts to start, given the magnitude of the problem.

“So in this context, what have the changes the ‘moderate senators’ done to the bill? Well, they took out big chunks of the aid to state and local governments, and increases in food stamps and health insurance assistance for the unemployed. In its place they put in a 10% tax credit to buy homes up to a limit of $15,000. The vast majority of homes sold in this country are existing homes, and buying or selling of them does exactly nothing to boost GDP, other than to help realtors commissions.

“New homes do add to GDP, but we have a housing glut, and at this point building new homes is simply mal-investment. Supposedly, this proposal will cost $18.5 billion. However, that estimate is merely proof of senatorial innumeracy.

“Let’s assume for sake of argument that 2009 home sales are the same as 2008. In 2008 there were 4.9 million existing homes sold, and almost another 500,000 new homes sold. Since the tax credit only goes to owner-occupied first homes (vacation homes and investment properties don’t qualify) let’s knock that total from 5.4 million down to 4.4 million. Since not all buyers will qualify for the full $15,000, let’s assume an average of $10,000 just to be conservative. Multiply 4.4 million times $10,000 and you get $44 billion, not $18.5 billion…

“While all government spending is stimulative, it is not all equally effective. Thus it is important focus on how to make the increase in G result in: A) leaving behind things of lasting value, the 21st century versions of the Interstate and the Hoover Dam, and B) helping those who are really hurting in this country, and who by the way are most likely to spend it fast and thus reduce the fall in C. These are the automatic stabilizers, the safety net.

“President Obama is right — spending is the point of stimulus. Spending can either be direct through expenditures, or indirect through tax cuts and credits. Tax cuts will attempt to stem the decline in C and I. However, we have allowed C to become far too large a part of the economy over a long period of time, and I will tend to follow C wherever it goes. Businesses will not want to invest to expand capacity when there is lots of unused capacity and the consumer has no interest, or ability, to buy those goods.

“Aid to states will prevent G from falling at a net basis. Doesn’t do much good to increase G at the federal level and have it immediately offset by cuts in G at the state and local level. Most S&L government employees are solid members of the shrinking middle class, cops, firefighters, regulators and teachers. Drastic cuts in S&L spending will further undercut the middle class. But with constitutional balanced budget requirements and plunging real estate and sales tax revenues, w/o federal aid, cuts are unavoidable.

“I suppose even a watered-down bill is better than nothing. Politically, however, that would be the best-case scenario for the GOP. Obama is going to own this, regardless of if he gets three GOP senate votes or fifteen. A weak bill that leaves the economy deeply depressed in 2010 will result in the voters turning away from the Democrats, as they will have been deemed to have failed to resurrect the economy.

“…For now I would stick with the most economically insensitive stocks with the best balance sheets. Those who have lots of excess cash, which can be used to gobble up other firms, and come out stronger on the other side, are the sorts of stocks you should be looking for.”